Fixed Income Portfolio Outlook for 2018

Year-end analysis shared by Charles Schwab suggests the appointment of Jerome Powell to be the new Federal Reserve leader likely means that interest rates will continue to move up slowly and cautiously.

Writing about his 2018 outlook for the U.S. and global fixed-income markets, Brett Wander, chief investment officer, fixed income, Charles Schwab Investment Management, foresees a slow and steady year. This is particularly true, he says, when it comes to the likely approach that will be taken by the incoming Federal Reserve Chair Jerome Powell.

“Jerome Powell will be the new Fed chair and likely do exactly what [former Fed Chair] Janet Yellen has been doing for years—move rates up very cautiously,” Wander says. “The last thing Powell wants is to spook the stock market by moving too quickly. And, with the continued lack of inflation, he’ll face more pressure to keep rates low than to normalize too fast. Look for two or three rate hikes in 2018, but don’t expect four.”

Looking back on a year of interest rate movements, Wander observes that today the yield spread between 2- and 10-year Treasuries is about 0.50%, “less than half of where we started 2017.” Wander says to “expect more flattening in 2018, maybe even yield curve inversion.”

“In the old days, an inverted curve foreshadowed slowing growth and a possible recession,” Wander writes. “But in the current environment, this model is obsolete. Inflation is tame, so longer-term yields don’t have to rise. Meanwhile, the Fed could easily raise rates 0.50% to 0.75%, making a flat or slightly inverted yield curve the new normal.”

Attempting to address interest rate risk is always a challenge for retirement investors, whether for individuals utilizing 401(k) accounts or for the largest pensions, but one approach commonly advocated for is the bond ladder. Experts argue bond ladders can work in a rising rate environment and across a variety of unpredictable macroeconomic scenarios—allowing investors to continually readjust their fixed-income exposure as the situation shifts.

According to Wander, 2018 will be a year to focus on fixed income portfolios.

“Another 20%-plus return for U.S. stocks is highly improbable in 2018,” he says. “Tax reform is already priced in and another significant injection of market euphoria seems unlikely. Instead, we’ll likely see continued turbulence on the Trump-front, and a great deal of uncertainty in the geopolitical realm. This could be bad for stocks but could be good for bonds.”

On the equities side of the equation, Omar Aguilar, chief investment officer, equities and multi-asset strategies, argues that the “second-longest bull market ever” still has room to run, with synchronized global growth providing a solid foundation for equities.

“The lack of inflation globally supports the Fed’s plans to raise rates gradually, while other central banks seem likely to maintain accommodative policies for most of 2018,” he concludes.